Futures Trading 101
Educational resources provided to assist investors learn the fundamentals of commodities trading
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Futures Trading 101
This is a rather lengthy introduction to futures trading. You can use the navigation at the top of the article to jump to a specific point within the article.
I. Disclaimer
The material contained on this page is intended solely to help give an introduction to futures trading, and in no way should be taken as futures trading advice or recommendations. We strongly encourage you to seek out further information about commodities trading from your broker or advisor, the U.S. Commodity Futures Trading Commission (CFTC), and the National Futures Association (NFA). Both the Commodity Futures Trading Comission and the NFA host a variety of excellent commodities trading educational materials on their websites, some of which we have included in our own futures trading educational section for your convenience.
II. Overview
i. Risk
The first thing any investor should know about the futures trading market is that it is risky, and only risk capital should be used to invest in it. The risk of loss can be significant, so consider the risk of such a loss in regards to your financial condition.
You should be careful of any advertising or other claims of potential for sizable profits in day trading. Furthermore, day trading on margin can lead to losses above your initial investment.
ii. Commodities Trading Futures Contracts
A futures contract in finance is a security (derivative contract) between two parties who agree to buy or sell a specific asset (gold, oil, wheat etc.) of standardized quantity and quality at a designated future date (the settlement date) and price. Futures contracts are exchange-traded derivatives.
The party buying the asset in the futures contract takes on a long position, while the party selling the asset in the futures contract takes on a short position.
The price of the asset is set by the market forces of equilibrium between the supply and demand of the underlying asset as well as between competing buy and sell orders for that type of contract on the futures exchange.
The types of assets that underlay futures contracts range from physical commodities like oil, gold or wheat to financial futures like currencies, securities or financial instruments (U.S. Treasure Bills), or intangible assets like a stock index and interest rates.
Prices for futures contracts fluctuate throughout day as demand interacts with supply, and the official final price at the end of the trading session on the exchange is called the settlement price for that day of commodities trading.
iii. Futures Trading Market Process
Note: in this article, and in general, the terms commodities trading and futures trading are loosely used interchangeably.
Futures contracts are exchange-traded derivatives, so each exchange has a clearing house that acts as a counter-party on all contracts, sets margin requirements, and provides a mechanism for settlement.
As a counter-party on all contracts, the exchange acts as the buyer to every seller and the seller to every buyer, which minimizes the counter-party risk to traders. Thus, the clearing house assumes the default risk.
iv. Futures Trading Contract Codes
Each futures contract consists of the type of commodity or asset being traded, the month the contract is for, and the year in which the contract is for.
Futures Trading Month Codes
- January = F
- February = G
- March = H
- April = J
- May = K
- June = M
- July = N
- August = Q
- September = U
- October = V
- November = X
- December = Z
Example: CLJ11 = Crude Oil WTI April '11
v. Futures Trading Settlement
There are two types of settlement (fulfilling the contract), and the chosen way is specified by the type of futures contract.
1. Physical delivery: the amount of the underlying asset specified in the contract at the quality specified is delivered by means specified in the contract by from the seller to the exchange, and is then delivered by the exchange to the buyer. Physical delivery is often used with commodities and bonds.
2. Cash settlement: a cash payment is made according to the terms of the contract. This method is often used when physical delivery of the asset is not possible, like with an index or interest rates.
vi. Commodities Trading Margin Requirements/ Performance Bond
Futures contracts are often traded on margin, or in other words only a small percentage of the total cost is actually put forth initially by the trader. Margin requirements are the amount of collateral that a trader has to post to minimize the risk of them defaulting. The collateral is deposited into a margin account.
Initial Margin: Set by the exchange, and is the initial equity required to enter into a futures contract.
Customer Margin: Set by FCM and IB, determined by market risk and the value of the contract.
Maintenance Margin: defines how much the value of the initial margin can reduce before a margin call is made. May also be called "variation margin".
Margin Calls: Margin calls occur when the value of the original margin is eroded, and the broker requests additional capital to restore the amount of the initial margin. While these types of calls are usually made on a daily basis, period of high volatility may require intraday margin calls. If the margin call is not paid on the same day the broker has the right to close the position to meet the amount called, in which case the client is liable for any resulting deficient in their account.
vii. Characteristics of a Contract in Commodities Trading
Futures contracts are standardized, which is what allows them to keep their liquidity. In commodities trading A contract will specify:
- 1.) The underlying asset or instrument, from a barrel of crude oil to a troy ounce of gold.
- 2.) Type of settlement – Cash or Physical.
- 3.) Amount of units of underlying asset per contract
- 4.) Currency in which the futures contract is quoted.
- 5.) The grade of the deliverable, i.e. the quality and manner or location of delivery. In abstract financial instrument futures this refers to which bonds can be delivered. Each asset will have its own measures of quality.
- 6.) The delivery month
- 7.) The last trading date.
- 8.) The commodity tick – or the minimum permissible price fluctuation.
viii. Futures Contracts Versus Options
In a futures contract the buyer or seller has an obligation to deliver or take the commodity according to the terms of the contract.
In an option on a futures contract the buyer or seller has the option to deliver or take the commodity according to the terms of the contract. Thus, in an option on a futures contract the buyer or seller would only exercise their option if it were financially beneficial to them.
ix. Futures Trading Regulation
Commodity Futures Trading Commission (CFTC): The United States futures trading industry is closely regulated by the Commodity Futures Trading Commission (CFTC), which was created by Congress in 1974 to regulate commodity futures and option markets in the U.S. On their website, the CFTC states: "The CFTC's mission is to protect market users and the public from fraud, manipulation, and abusive practices related to the sale of commodity and financial futures and options, and to foster open, competitive, and financially sound futures and option markets." The CFTC's regulations can be found at Title 17 Chapter I of the Code of Federal Regulations (CFR), and much more information is available at their website: www.cftc.gov.
National Futures Association (NFA): The National Futures Association is the independent, self-regulatory organization for the U.S. futures trading industry. On their website, the NFA states they "strive every day to develop rules, programs and services that safeguard market integrity, protect investors and help our Members meet their regulatory responsibilities." More information is available at their website: www.nfa.futures.org
III. Commodities Trading Market Intermediaries
The intermediaries in the futures trading market include Futures Commission Merchants (FCM), Introducing Brokers (IB), Commodity Pool Operators (CPO), and Commodity Trading Advisors (CTA). Intermediaries are generally required to register with the CFTC and, depending on their activities, are subject to many financial, disclosure, reporting, and record-keeping requirements.
i. Introducing Brokers (IBs)
As the CFTC website states, a futures trading introducing broker is one "who is engaged in soliciting or in accepting orders for the purchase or sale of any commodity for future delivery on an exchange who does not accept any money, securities, or property to margin, guarantee, or secure any trades or contracts that result therefrom."
ii. Futures Commission Merchants (FCM)
As the CFTC website states, [in commodities trading] FCMs "Solicit or accept orders for futures or options contracts traded on or subject to the rules of an exchange" and "in or in connection with such solicitation or acceptance of orders, accepts money, securities, or property (or extends credit in lieu thereof) to margin, guarantee, or secure any trades or contracts that result or may result."
IV. How to Get Started
Before anything else, make sure you understand the inherent risks in futures trading. We suggest you review the risk page of our website.
Make sure you are fully informed about the process of futures trading. We encourage you to read the materials we have on our website, as well as the CFTC's and NFA's commodities trading educational materials.
Once you feel fully prepared you should find a suitable broker through which you wish to participate in the futures trading market, and call them to get started.
Trading commodity futures and options involves substantial risk of loss. The recommendations contained are of opinion only and do not guarantee any profits. These are risky markets and only risk capital should be used. Past performances are not necessarily indicative of future results. This is not a solicitation of any order to buy or sell, but a current futures market view. Any statement of facts herein contained are derived from sources believed to be reliable, but are not guaranteed as to accuracy, nor they purport to be complete. No responsibility is assumed with respect to any such statement or with respect to any expression of opinion herein contained. Readers are urged to exercise their own judgment in trading!
